HubSpot: Lengthening The Growth Runway

About: HubSpot, Inc. (HUBS)
by: Mark Ashton

HubSpot management is firmly focused on expanding its target market and cross-sell opportunities for the company across its three hubs.

R&D focus remains strong, and the company should benefit from operating leverage as it scales.

With shares trading below peers, I am optimistic on HubSpot shares at this stage.

HubSpot is a Software as a service (NASDAQ:SAAS) company focused on marketing, sales and services offerings to clients across different sizes in terms of revenue. Starting as a marketing app, the company has successfully pivoted to a full-fledged CRM platform with ~65,000 paying subscribers as of Q2 2019.

The company has thus far, been focused on large enterprises but has now started to focus on small and medium scale businesses through its freemium strategy. The strategy has worked well - HubSpot has delivered solid top-line growth along with rapidly improving margins.

I am bullish on HubSpot's strategic shift and expect the company to penetrate its target customer segment further and also expand its market through existing and new offerings. Shares are trading at a lower-than-industry revenue multiple and seem like a good buy at this stage.

Inbound 2019 Takeaways

HubSpot recently highlighted its key financial and operational pillars at its Inbound 2019 event, as well as its latest strategic shift, moving from an app to a full-fledged platform catering to marketing, sales, and services needs of individuals and enterprises.

Source: Pg 25 of Inbound 2019 Presentation

FY2018 was a pivotal year in terms of investing in the building of this suite. Now, the suite/platform is well-equipped to cater to the needs of companies of all sizes. For now, the focus of the company will remain to increase its small and medium scale businesses (SMBs) rather than enterprise customers.

I think this makes a lot of sense from a margin perspective - the cost to acquire a Starter customer is 1/10th that of a Pro/Enterprise customer.

Source: Pg 45 of Inbound 2019 Presentation

The volume play seems to have worked well - the onboarding of individual and SMB users has grown rapidly in the past few quarters.

QE Jun 2018 QE Jun 2019 % Change
# of Customers 48,091 64,836 34.8%
Average Subscriber Revenue ($) 10,004 9,913 -0.9%

Source: 10Q filing

This data points to the fact that the freemium strategy is working well. A reduction in average subscriber revenue means that the company has been able to attract a lot of first-time subscribers who are using basic lower-priced services and are expected to upgrade to the higher priced plans later. The annual recurring revenue (ARR) of customers who were once using the free features and have now moved to the paid ones is at a healthy 60%+ level.

Source: Pg 17 of Inbound 2019 Presentation

The company seems to have hit a goldmine by packaging different related services to all types of customers as “layers” which interact seamlessly with each other. A customer who is already using one of the layers is likely to go for HubSpot’s other layers because of the ease of integration and awareness of the company’s UI. Moreover, even if some of the services are not available, the company has launched an app store where users can integrate apps of other companies if need be. This strategy is already showing results with a steady increase in multi-product revenue as a percentage of total revenue.

Source: Pg 26 of Inbound 2019 Presentation

In addition to increasing revenue, the traction in its non-core sales and services products will help solidify the platform investment flywheel. Higher customer satisfaction and word of mouth marketing will not only increase margins due to lowered customer acquisition costs (NASDAQ:CAC), HubSpot can also reinvest the savings into building a better platform.

The company has also increased its total addressable market (NYSE:TAM) by including non-marketing related hubs in its list of product offerings. I expect the addressable market opportunity to expand further as the company continues adding service layers and targets more customer segments.

Financial Review

The company has been able to improve its profitability over the years by scaling up and gaining the benefit of operating leverage. Though the company has expanded and matured somewhat, it has maintained a focus on R&D, which has maintained at 23% of revenue.

as % of Revenue QE Jun 2018 QE Jun 2019 % Change
GM % 81% 80% 1%
R&D % 25% 23% 2%
S&M % 52% 53% -1%
G&A % 14% 15% -1%

Source: 10Q filing

There will be some dips ahead - management expects FY2020 margins to be flat as compared to FY2019. One of the key contributors is the slower-than-expected pace of hiring in H1-2019, which will need to be pushed into H2-2019 and FY2020, impacting margins in future quarters.

Moreover, the company is guiding toward an increase in prices across the board, which may be beneficial to the gross margin %, but it remains to be seen how elastic the company’s subscribers are vis-a-vis the price hikes.

Another key segment to monitor will be the professional services business, which remains loss-making. Though the loss has reduced YoY, the company needs to focus on pricing and employee cost levers in order to increase its profitability further.

Source: 10Q filing

For a company like HubSpot, which is not profitable at EBITDA or Net Margin level, EV/Sales is the default metric of comparison. Since most of the company's investments are front-loaded to develop technology and platforms, margins tend to be lower in the initial years. Comparing HubSpot’s EV/Sales multiple to its peers, it appears the company is slightly undervalued. With most of the developments highlighted in the Analyst Day being positive, I believe the company has plenty of untapped growth potential ahead. Furthermore, Hubspot's discount to peers on an EV/Sales basis is appealing despite appearing lofty at ~13x.



Overall, HubSpot's freemium strategy to focus on individuals and SMBs seems to be paying off - the company has grown 35% YoY in subscribers. Further expansion into adjacent business functions through expanded offerings could pay off over the medium to long run with multi-product revenue contribution rising over the past few quarters.

The continued focus on R&D is also a key positive, with HubSpot still early on its growth trajectory. If the company can continue on its current path, I believe it should be able to meet its growth and margin objectives in future. Though the EV/sales multiple is lofty at 13.0x, the relative undervaluation vs peers as well as the growth potential ahead keeps me bullish on HubSpot shares.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.